Oil investors hold nerve, despite doubters

Near record oil prices are expected to keep most investors keen, even though one of the Dutch pension funds that helped to lead an inrush of financial players is reviewing its exposure.

ABP, one of the world's largest pension funds, last week said it might reduce its holdings in oil assets in favor of other commodities.

Other investors have been reviewing the way they buy into energy, but for the majority there is still potential in a direct approach.

We have just seen some great short-term price movement, reducing exposure might be a sensible short term move. said Mark Mathias, chief executive of commodity fund manager Dawnay Day Quantum. However, given the fundamentals I would not be underweight oil.

A number of big pension funds have taken the plunge into commodities and energy since around 2004 to diversify portfolios, boost returns and hedge against inflation.

In Europe, Dutch pension funds were at the forefront of the shift. Last year, Hermes, Britain's largest private sector fund and the biggest U.S. pension fund CalPERS also moved into commodities.

In total, some $100 billion of institutional money is invested in commodities, according to estimates from Barclays Capital survey of fund managers in February.

The influx helped to push prices to a record of $78.65 for Brent in August last year, only slightly higher than a price of nearly $77 on Thursday.

Pension fund investors have traditionally gained exposure to energy via benchmark indexes such as the S&P GSCI, which has around a 70 percent energy weighting.

But the structure of the crude oil futures market, where crude nearby has been cheaper than further forward, has hit returns from the S&P GSCI as index investors have to roll positions forward every month.

And last year the index fell by 15 percent, its first fall since 2001.

REDUCING EXPOSURE

Several large institutional investors have been driven by past performance to reduce exposure, said Douglas Hepworth, director of research at commodities fund manager Gresham Investment Management.

Some have reduced exposure to energy futures but have either replaced or are endeavoring to replace that exposure with private equity investments in the energy sector.

But now the crude oil market's structure has shifted into backwardation, which means oil prices nearby are higher than those further forward. This delivers positive returns when index investors roll their positions forward each month.

The S&P GSCI fell in April and May, but posted gains in June of 4.7 percent and 4.9 percent in July to date, according to Barclays Capital research.

This would suggest that this may be precisely the wrong time to be moving out of energy and into other commodities, said Aoifinn Devitt of investment consultancy Clontarf Capital.

The problem with substituting other commodities for oil exposure is that there is not as much liquidity in these markets, she said, pointing to agricultural commodities as an example.

Another factor in energy's favor is that the energy component of the S&P GSCI index has historically offered the greatest diversification relative to other asset classes such as stocks and bonds.

Oil price increases have often coincided with equity market weakness, said Richard Cooper of Mercer Investment Consulting. This diversification argument has even led some investors to further overweight the energy sector, even beyond the bias of the S&P GSCI.

Investors seeking a lower exposure to energy can use other indexes such as the Dow Jones AIG index, which has an energy weighting capped at about 33 percent.

But some pension funds are wary of the so-called negative roll-yield that hits index returns when oil prices nearby are cheaper than those further in the future -- known as contango.

More and more pension funds are trying to move into enhanced products although still largely long-biased, said Devitt. The more sophisticated groups are seeking to structure their own exposures with banks.

The drive to boost returns and protect against the risk of a big stock market downturn is expected to draw more pension funds and institutional investors into energy and commodities.

In terms of institutional money there's still a developing interest in commodities as a whole, said Paul Horsnell, head of commodities research at Barclays Capital.